A long-awaited decision came out in the end of November that affects all cannabis businesses. In this case, the Tax Court denied a California medical-marijuana dispensary’s deduction of ordinary and necessary business expenses and some of its costs of goods sold. This decision serves to provide more clarification for cannabis businesses, CPAs, and tax attorneys on the best ways to minimize the harsh effects of IRC S 280E. Patients Mutual Assistance Collective Corporation d/b/a Harborside Health Center v. C.I.R., U.S. Tax Court (San Francisco, CA), Case Nos. 29212-11; 30851-12; 14776-14, 2018 WL 6271696 (T.C. Nov. 29, 2018).
Harborside conducted four different types of business activities, each of which was a separate trade or business: the sale of marijuana and products containing marijuana, the sale of products containing no marijuana, caregiving services, and brand development. Harborside took ordinary and necessary business deductions in relation to its sales of non-marijuana products and caregiving services. Additionally, Harborside used S 263A capitalization regulations as opposed to S 471 to further attempt to lower its tax liability. The Tax Court disallowed the dispensaries deductions in relation to its ancillary services/sales and determined that cannabis businesses cannot use S 263A capitalization regulations and instead must use S 471. (and others that traffic Schedule I or II drugs).
To give a brief overview of the tax laws that apply to cannabis businesses, under S 162A, a typical business may deduct from its gross income all the ordinary and necessary expenses paid or incurred during the tax year in carrying on the trade or business. However, under S 280E, no “deduction or credit shall be allowed for any amount paid or incurred during the tax year in carrying on any trade or business if such trade or business (or the activities which comprise such trade or business) consists of trafficking in controlled substances.” Thus, a taxpayer may not deduct any amount for a trade or business where the trade or business consists of trafficking a Schedule I or II controlled substance.
In a landmark marijuana case, Californians Helping to Alleviate Med. Problems, Inc., (2007) 128 TC 173 (“CHAMP”), the taxpayer, CHAMP, charged a membership fee for the caregiving services and medical marijuana it provided to its members. The IRS disallowed all of CHAMP’s deductions under S 280E. The Tax Court held that marijuana is a schedule I controlled substance, even if it is recommended by a physician. However, the Tax Court allowed CHAMP to deduct its expenses attributable to its counseling and other caregiving services. The Court rejected the IRS’s contentions that CHAMP was engaged in a single business activity (trafficking in marijuana) or that S 280E required the denial of all CHAMP’s expense deductions of ancillary services/sales. Since this case, cannabis businesses have gotten creative and expanded on this holding.
When S 280E was enacted, taxpayers using an inventory method were subject to the inventory-costing regulations under S 471. Four years after enacting S 280E, Congress added the uniform capitalization (UNICAP) rules of S 263A to the Code. Under S 263A(a), resellers and producers of merchandise are required to treat as inventoriable costs the direct costs of property purchased or produced, respectively, and a proper share of those indirect costs that are allocable to that property. However, flush language at the end of S 263A(a)(2) provides, “Any cost which (but for this subsection) could not be taken into account in computing taxable income for any tax year shall not be treated as a cost described in this paragraph.” S 263A helps businesses reduce thir tax liability because they are permitted to include additional expenses, including purchasing, handling and storage expenses, and service costs.
Further, Chief Counsel Advice (CCA) 201504011 memo concluded that although marijuana-related businesses are permitted to determine COGS, they must do so using the S 280E as it was enacted in 1982 and S 471, which makes the provision for the use of inventories to determine business income. When S 280E was enacted in 1982, an inventoriable cost referred to any costs that could be capitalized to inventories under S 471.Capitalization simply means delaying the recognition of an expense by treating the item as a fixed asset rather than recognizing the cost in the period that it was incurred.
Now we have both the CCA and the Harborside decision instructing cannabis businesses that they cannot use S 263A to reduce tax liability and instead must continue to use S 471.
About the Author: Paula Savchenko is an associate attorney at the Law Offices of Moffa, Sutton, & Donnini, P.A, based in Fort Lauderdale, Florida. Ms. Savchenko joined the firm in 2013 and practices primarily in the areas of Taxation and Administrative Law matters, as she counsels and represents businesses and individuals in their dealings with government agencies. More specifically, most of her work involves tax and regulatory matters, with an emphasis on state and local taxation.